Purposely Not Seeking Revenue or Profit Growth

A new stock screen I created omits one characteristic that may surprise some (or perhaps many) of you: growth. Nothing in the screen requires a passing company to be growing revenues or profits. It is an admitted deviation from how I’ve previously looked for stocks.

I’m not alone in omitting growth. The four AAII Stock Screens with the best long-term performance all do not seek growth: Estimate Revisions Up 5%, Piotroski High-F Score, Estimate Revisions Top 30 Up and O’Shaughnessy Tiny Titans. Add in Price-to-Free-Cash Flow, and five of the seven screens with the best performance since the start of 1998 (when we started tracking the returns for our screens) do not specifically require growth. Even our Model Shadow Stock Portfolio—a real-world portfolio—has a long-term annualized return of 15.5% since its inception in 1993. This compares to the Vanguard Small Cap Index fund’s (NAESX)return of 9.9% over the same period.

There’s no argument about whether growth is a positive trait. Rising revenues can drive profits, cash flow and retained earnings higher. It can also increase the denominator in the price-earnings, price-to-cash-flow and price-to-book ratios (and will obviously increase the denominator in the price-to-sales ratio). When the denominator in a valuation ratio grows, either the stock’s price has to rise or its valuation will become cheaper. Growth in cash flow also allows a company to raise its dividend and buy back more shares, all positive things. The problems with growth are what one pays for it and the ability to forecast it.

Stop and think about how much attention growth stocks get. Investors love growth stories, as well as stories about companies with the potential for explosive growth. As these stories circulate, the stocks get more attention, more fans and higher valuations. Lost in the hoopla is the opportunity for mispricing. Stocks priced below their fair valuation are investors’ friends; you’re unlikely to find them where the crowds are standing.

The long-term record backs this up. The 2016 SBBI Yearbook reports large-cap value stocks as realizing an annualized return of 11.0% between 1928 and 2015, besting large-cap growth stocks by a margin of slightly more than 20%. (Large-cap growth stocks have a long-term annualized return of 9.1%). The difference is bigger among small-cap stocks: 13.7% for value versus 9.3% for growth. Granted, value stocks don’t outperform all the time, but they do win more often than not. Large-cap value stocks realized higher returns than large-cap growth stocks during six out of the last eight completed decades, 1930-2010. Admittedly, growth has had the advantage over the past few years, but if the long-term historical trends hold, the pendulum will swing back in favor of value.

Setting aside returns, there is the problem of being able to predict growth. Analysts are notoriously bad at it. Plus, various studies have shown that forecasting skills deteriorate the further out an analyst tries to predict profits. This is why some strategies set an upper limit on the price-earnings-to-earnings-growth (PEG) ratio. Doing so allows for a margin of error. While I could do the same, I think it’s better to forgo seeking out growth and simply find profitable and cash-flow-positive companies that are likely to be trading at bargain prices.

So, if I’m omitting growth, what I am looking for? The actual screen is being reviewed to ensure I didn’t inadvertently make an error in creating the custom criteria I intend to use, but I can give you an overview.

Low valuation: Specifically in the bottom 40% of all stocks

Profitability: Companies must be profitable for the past 12 months, last reported quarter and projected to be profitable for the current fiscal year

Positive cash flow: Normal business operations must be generating more cash than they use

Momentum: Passing stocks must rank in the top 40% of all stocks for 26-week return

I will then use a scoring system to rank the passing stocks based on the following criteria:

Accruals: As I explained last week, stocks with low accruals tend to outperform

Improving asset turnover: An increase in this ratio implies a company is becoming more efficient

Decrease in relative debt: Used to avoid companies taking on more leverage

Taking a step back to look at the broader picture, the screen incorporates three factors: value, momentum and quality. Viewed another way, this is a value screen designed to weed out value traps by seeking out stocks with momentum and deemphasizing companies with weaker fundamentals. By using a two-step process of screening and then ranking the results by a score, I am allowing the screen to be inclusive enough to find many names while still having a mechanism to weed out the riskier stocks.

August new home sales will be the first economic report of note, released on Monday. Tuesday will feature the July S&P Case-Shiller home price index (HPI) and the Conference Board’s September consumer confidence survey. August durable goods orders will be released on Wednesday. Thursday will feature August international trade, August pending home sales and the second revision to second-quarter 2016 gross domestic product (GDP). August personal income and spending, the September Chicago purchasing managers index (PMI), and the University of Michigan’s final September consumer sentiment survey will be released on Friday.

Federal Reserve Chair Janet Yellen will speak on Thursday. Several other Federal Reserve officials will also make public appearances: Minneapolis president Neel Kashkari on Monday and Wednesday; Dallas president Robert Kaplan on Monday; St. Louis president James Bullard, Chicago president Charles Evans and Cleveland president Loretta Mester on Wednesday; Kansas City president Esther George on Wednesday and Thursday; and Philadelphia president Patrick Harker, Atlanta president Dennis Lockhart and board governor Jerome Powell on Thursday.

The Treasury Department will auction $26 billion of two-year notes on Monday, $34 billion of five-year notes on Tuesday, and $13 billion of two-year floating rate notes and $28 billion of seven-year notes on Wednesday.